FIN Exam 3

Question 1

Given the risk of XYZ Corp. common stock, your required rate of return is 16%. Given the current economic conditions and the current market price of the stock, you determine that the stock’s expected return for the upcoming year is 14%. Which of the following is true?

a) The stock is overpriced.
b) The stock is underpriced.
c) The stock is correctly priced.
d) The stock price should rise.
e) Both B and D are correct.

Answer 1

A. The stock is overpriced.

Question 2

Medical Supply Company has a beta of 1.55 and recently paid a common stock dividend of $3.47. If the return on Treasury securities is currently 7.5% and the return on the S&P 500 index is 12%, what is the required rate of return on the firm’s common stock?

a) 7.5%
b) 26.1%
c) 18.5%
d) 12.93%
e) 14.48%

Answer 2

E. 14.48%

Question 3

Dimensions Corporation’s preferred stock recently paid its annual dividend of $6.75 per share. The par value of the preferred stock is $100. Investors require a 9% rate of return on this stock. What is the intrinsic value of the preferred stock?

a) $1,000
b) $75
c) $100
d) $1,111
e) $833

Answer 3

B. $75

Question 4

Food Chain, Inc. common stock recently paid a dividend of $2.60. The firm typically pays out 50% of its earnings as dividends and retains the rest for investment in the firm. Food Chain has a return on equity of 15 percent. If investors require a return of 12 percent, what is the intrinsic value of the firm’s common stock? Assume dividends will grow at a constant rate.

a) $21.67
b) $23.29
c) $62.11
d) $24.92
e) $57.78

Answer 4

C. $62.11

Question 5

Hampton Corporation’s common stock dividends are expected to grow by 8% per year. Recently, the firm paid a $3.00 common stock dividend. Hampton has a beta of 1.40. The expected return on the S&P 500 index is 12.5% and the rate of return on U.S. Treasury securities is 7%. Using this information and the CAPM, what is the stock’s intrinsic value?

a) $72
b) $66.67
c) $24
d) $48.35
e) $25.92

Answer 5

D. $48.35

Question 6

TPI Company common stock is currently selling for $80. Industry analysts are forecasting a dividend of $4.60 for next year and a growth rate of 8 percent per year for the foreseeable future. What is the expected annual rate of return for the stock?

a) 8.06%
b) 5.75%
c) 13.75%
d) 14.21%
e) 15.28%

Answer 6

C. 13.75%

Question 7

In one year, Hitech Microdevices will pay a common stock dividend of $4.35. You predict that you will be able to sell your Hitech stock for $57 per share after 1 year. If you require a rate of return of 16 percent on Hitech stock, how much would you be willing to pay now for a share of the stock?

a) $45.39
b) $52.89
c) $49.14
d) $71.17
e) $53.49

Answer 7

B. $52.89

Question 8

Rosen Fashions’ common stock recently paid a dividend of $2.75. Investors require a 18% rate of return on this stock. Rosen earns a 30% return on equity. The firm pays 55% of its earnings as dividends, and reinvests 45% of earnings in the firm. What is the value of the stock?

a) $61 d) $15
b) $69 e) $17
c) $208

Answer 8

B. $69

Question 9

Clayton Corporation common stock is expected to pay a dividend of $2.95 in one year. Company earnings and dividends are expected to grow at an annual rate of 9 percent. If you can buy this stock for $34.71, what is your expected return?

a) 9.3% d) 18.3%
b) 8.5% e) 17.5%
c) 34.6%

Answer 9

E. 17.5%

Question 10

You expect Technomess Company common stock to pay a dividend of $2.40 one year from now. You can buy the stock now for $52, and you plan to sell the stock at the end of one year. Given the risk of the stock, your required rate of return is 16%. For what price would you need to sell your stock in one year in order to earn your required rate of return?

a) $58 d) $60
b) $15 e) $63
c) $22

Answer 10

A. $58

Question 11

You are interested in buying 100 shares of Diversified Company’s $60 par value preferred stock. The stock has a dividend rate of 8.5%. If your required return is 11 percent, how much would you be willing to pay to acquire the 100 shares?

a) $7,727
b) $4,636
c) $129,412
d) $7,765
e) $6,000

Answer 11

B. $4,636

Question 12

Warp-O Corporation common stock has a market price of $45 per share. Warp-O has a beta of 1.4. The rate of return on Treasury bonds is currently 6% and the return on the S&P 500 is 13%. What is the required rate of return on Warp-O common stock?

a) 10.2% d) 24.2%
b) 13.0% e) 35.1%
c) 15.8%

Answer 12

C. 15.8%

Question 13

McCall Corporation has a capital structure consisting of 55 percent common equity, 30 percent debt, and 15 percent preferred stock. Any debt issues would have a pre-tax cost of 9.5%. Preferred stock can be issued for a cost of 11.5%. Common equity can be issued, but flotation costs of $4.25 per share of common stock would be paid. McCall common stock is currently selling in the market at $65 per share. McCall recently paid a dividend of $4 per share and company earnings and dividends are expected to grow at an annual rate of 8% indefinitely. McCall has a tax rate of 21% and the firm wants to keep its current capital structure. If the firm needs to raise additional equity, what will be the firm’s cost of capital?

a) 11.76% d) 11.99%
b) 12.04% e) 12.89%
c) 12.29%

Answer 13

C. 12.29%

Question 14

A firm has $5 million in retained earnings. The market price of the firm’s common stock is $55. The firm recently paid a dividend of $3.70. Earnings and dividends are expected to increase at an annual rate of 9 percent. When new common stock is issued, flotation costs amount to 4 percent of market price. What is the firm’s cost of external equity financing?

a) 7.6% d) 16.3%
b) 16.0% e) 15.7%
c) 16.6%

Answer 14

C. 16.6%

Question 15

A firm recently issued $1,000 par value, 20-year bonds with a coupon rate of 9%. Coupon interest payments will be paid semi-annually. The bonds sold at par value, but the firm paid flotation costs amounting to 5% of par value. The firm has a tax rate of 21%. What is the firm’s after-tax cost of debt for these bonds?

a) 9.57% d) 7.74%
b) 7.56% e) 7.04%
c) 7.11%

Answer 15

B. 7.56%

Question 16

Seminole Corporation common stock currently sells for $32 per share. The firm recently paid a dividend of $1.25 per share. Flotation costs for new external equity are $3 per share. Analysts have forecast that earnings and dividends will grow at an average annual rate of 7% percent well into the future. What is the company’s cost of internal equity?

a) 11.18%
b) 10.91%
c) 11.61%
d) 12%
e) 11.31%

Answer 16

A. 11.18%

Question 17

A firm has preferred stock that pays an 8 percent dividend on a $75 par value. If a new issue is offered, flotation costs will be 4 percent of the current market price of $70. The firm’s tax rate is 21 percent. What is the firm’s cost of preferred stock financing?

a) 5.9% d) 8.5%
b) 10.7% e) 11.9%
c) 8.9%

Answer 17

C. 8.9%

Question 18

Alpha Products maintains a capital structure of 40 percent debt and 60 percent common equity. To finance its capital budget for next year, the firm will sell $50 million of 11 percent bonds at par value (assume no flotation costs). The firm will finance the rest of its $125 million in capital expenditures with retained earnings. Next year, Alpha expects net income to grow 7 percent to $140 million, and dividends also are expected to increase 7 percent to $1.40 per share and to continue growing at that rate for the foreseeable future. The current market value of Alpha’s common stock is $30 per share. If the firm has a tax rate of 21 percent, what is its weighted cost of capital for next year?

a) 10.48% d) 11.40%
b) 9.88% e) 10.98
c) 12.22%

Answer 18

A. 10.48%

Question 19

Easy Rider Inc. sold a 15 year $1,000 face value bond with a 10 percent coupon rate. Interest is paid annually. After flotation costs, Easy Rider received $928 per bond. Compute the after-tax cost of debt for these bonds if the firm’s tax rate is 21 percent.

a) 9.80% d) 8.69%
b) 11.00% e) 17.38%
c) 7.75%

Answer 19

D. 8.69%

Question 20

Western Airlines is planning to sell $10 million of preferred stock. The par value of the preferred is $50 per share. The annual dividend will be 13% (preferred dividends are typically quoted as a percent of par value). The market value of the preferred is $50 per share. Issuance costs are expected to be $2 per share. Western has a tax rate of 21 percent. What is the company’s cost of preferred stock?

a) 27% d) 8.12%
b) 13.54% e) 7.80%
c) 13.00%

Answer 20

B. 13.54%

Question 21

The White Corporation has a capital structure of 60 percent common equity, 10 percent preferred stock, and 30 percent debt. This capital structure is believed to be optimal.

To finance expansion plans over the coming year, the firm expects to have $40 million in retained earnings available. The cost of retained earnings is 18 percent. Additional common equity can be obtained by selling new common stock at a cost of 19.6 percent.

Preferred stock can be sold at a cost of 15 percent.

$25 million in secured bonds can be sold at a pretax cost of 14 percent. Beyond $25 million, the firm would have to sell unsecured bonds (debentures) at a pretax cost of 15 percent. The firm’s tax rate is 21 percent.
What is the firm’s lowest weighted cost of capital?

a) 15.62% d) 16.82%
b) 16.50% e) 15.86%
c) 16.58%

Answer 21

A. 15.62%

Question 22

The White Corporation has a capital structure of 60 percent common equity, 10 percent preferred stock, and 30 percent debt. This capital structure is believed to be optimal.

To finance expansion plans over the coming year, the firm expects to have $40 million in retained earnings available. The cost of retained earnings is 18 percent. Additional common equity can be obtained by selling new common stock at a cost of 19.6 percent.

Preferred stock can be sold at a cost of 15 percent.

$25 million in secured bonds can be sold at a pretax cost of 14 percent. Beyond $25 million, the firm would have to sell unsecured bonds (debentures) at a pretax cost of 15 percent. The firm’s tax rate is 21 percent.

What is the firm’s highest weighted cost of capital?

a) 15.62% d) 16.82%
b) 16.50% e) 15.86%
c) 16.58%

Answer 22

D. 16.82%

Question 23

Consider the following cash flows for two mutually exclusive capital investment projects. The required rate of return is 12%. Use this information for the next 5 questions.

LOOK AT CHAPTER 10, QUESTION 1

What is the IRR of project A?

a) 18.69%
b) 12.97%
c) 10.05%
d) 16.32%
e) 16.58%

Answer 23

D. 16.32%

Question 24

What is the profitability index of project A?
a) 1.128 d) 1.09
b) 1.045 e) 1.117
c) .98

Answer 24

E. 1.117

Question 25

What is the payback period of project A?
a) 3.5 years c) 4.57 years e) 3.8 years
b) 3.43 years d) 3.57 years

Answer 25

B. 3.43

Question 26

Calculate the net present value of project B.

a) $1,842 d) $1,415
b) $3,802 c) $3,471 e) $2,223

Answer 26

A. 1,842

Question 27

Which of the following statements is true concerning projects A and B?

a) Both NPV and IRR lead to the same investment decision.
b) Due to time disparity, IRR indicates that project A should be accepted and NPV indicates that project B should be accepted.
c) Due to time disparity, IRR indicates that project B should be accepted and NPV indicates that project A should be accepted.
d) Due to size disparity, IRR indicates that project A should be accepted and NPV indicates that project B should be accepted.
e) Due to size disparity, IRR indicates that project B should be accepted and NPV indicates that project A should be accepted.

Answer 27

E) Due to size disparity, IRR indicates that project B should be accepted and NPV indicates that project A should be accepted.

Question 28

Each of two mutually exclusive projects involves an investment of $120,000. The firm’s required rate of return is 11%. Use this information for the next 2 questions. The estimated cash flows are as follows:

LOOK AT QUESTION 6 IN REVIEW

Which of the following statements best describes projects A and B?

a) Project A has a larger IRR than project B.
b) Project A has a larger NPV than project B.
c) Project B has a larger IRR than project A.
d) Both (b) and (c) are correct.
e) None of the above are correct.

Answer 28

a) Project A has a larger IRR than project B.

Question 29

Which of the following statements is true concerning projects A and B?

a) Both NPV and IRR lead to the same investment decision.
b) Due to time disparity, IRR indicates that project A should be accepted and NPV indicates that project B should be accepted.
c) Due to time disparity, IRR indicates that project B should be accepted and NPV indicates that project A should be accepted.
d) Due to size disparity, IRR indicates that project A should be accepted and NPV indicates that project B should be accepted.
e) Due to size disparity, IRR indicates that project B should be accepted and NPV indicates that project A should be accepted.

Answer 29

b) Due to time disparity, IRR indicates that project A should be accepted and NPV indicates that project B should be accepted.

Question 30

Your firm has estimated the following cash flows for two mutually exclusive capital investment projects. The firm’s required rate of return is 13%. Use this information for the next 3 questions.

LOOK AT QUESTION 8 IN REVIEW

What is the NPV of project B?

a) $1,526 d) $1,648
b) -$14,038 e) $44,500
c) $15,529

Answer 30

A. $1,526

Question 31

What is the payback of project A?

a) 2.3 years d) 3.5 years
b) 2.5 years e) 4.5 years
c) 3.0 years

Answer 31

D. 3.5

Question 32

Which of the following statements best describes projects A and B?

a) Project A should be accepted because it has the highest NPV.
b) Project A should be accepted because it has the highest EAA.
c) Project B should be accepted because it has the highest EAA.
d) Both projects should be accepted because they have positive NPVs and EAAs.
e) Neither project is acceptable.

Answer 32

c) Project B should be accepted because it has the highest EAA.

Question 33

Metro Corporation will spend $1 million for special manufacturing equipment. Shipping and installation charges will amount to $175,000 and an initial increase in net working capital of $50,000 will be required. The equipment will replace an existing machine that has a salvage value of $85,000 and a book value of $140,000. If Metro has a tax rate of 21%, what is the amount of the initial outlay for this project?

a) ($1,128,450)
b) ($1,225,000)
c) ($1,310,000)
d) ($1,140,000)
e) ($1,105,350)

Answer 33

a) ($1,128,450)

Question 34

Shell Biotech Corporation is considering two mutually exclusive capital investment projects. Project 1 costs $75,000, and would produce annual cash flows of $16,200 for each of the next 9 years. Project 2 also costs $75,000, but would produce annual cash flows of $14,000 for each of the next 12 years. If Shell’s cost of capital is 11%, which alternative should be chosen?

a) Project 1 should be accepted. d) Neither is acceptable.
b) Project 2 should be accepted. e) Projects 1 and 2 cannot be compared.
c) Both projects should be accepted.

Answer 34

a) Project 1 should be accepted.

Question 35

Jefferson Corporation is purchasing equipment with a 10-year life which will increase revenue by $38,000 per year and increase expenses by $21,000 per year. The cost of the project is $24,000, and the equipment has a salvage value of $9,000 at the end of the tenth year. The project will require a $6,000 investment in net working capital immediately. The equipment will be depreciated for 10 years using simplified straight line. Jefferson’s tax rate is 21%.

Calculate the total year 10 net cash flow, including both the last annual cash flow and the project’s terminal cash flow.

a) $27,044 d) $21,044
b) $13,934 e) $24,644
c) $22,934

Answer 35

a) $27,044

Question 36

The _______ approach is used by corporations that attempt to consider differential project risk in their capital budgeting procedures.

a) internal rate of return d) risk adjusted discount rate
b) equal annual annuity e) all of the above
c) net present value

Answer 36

d) risk adjusted discount rate

Question 37

Windsor Corporation is considering an investment which will require the purchase of a machine. The machine costs $800,000, has a class life of 5 years, and will be depreciated using simplified straight-line depreciation. The firm’s tax rate is 21%. The incremental cash inflows expected during the 5-year life of the project are $240,000 per year, and cash expenses are $80,000 per year. In addition, the new machine will reduce defects by $15,000 per year. The new machine will require a one-time increase in net working capital of $25,000 at the time of installation. At the end of 5 years, the machine will be worthless, and the firm will not replace it.
Calculate the annual cash flow resulting from this project.

a) $171,850 d) $138,250
b) $11,850 e) $298,250
c) $141,850

Answer 37

a) $171,850

Question 38

Heron Corporation is planning to add manufacturing capacity by installing new high-tech machines. The machines would increase revenues by $180,000 per year and increase costs by $50,000 per year. The new machines cost $560,000 and would be depreciated over 5 years using simplified straight line. Investment in net working capital of $30,000 would be required at the time of installation. The firm is planning to keep the machines for 7 years and then sell them for $80,000. The firm has a required rate of return on investment projects of 13% and a tax rate of 21%. What is the net present value of this project?

a) ($146,055) d) ($26,209)
b) ($13,457) e) ($18,015)
c) ($53,073)

Answer 38

b) ($13,457)

Question 39

Which of the following cash flows are not considered in the calculation of the initial outlay for a capital investment proposal?

a) increase in net working capital.
b) cost of issuing new bonds to finance the new project.
c) delivery costs.
d) installation costs.
e) proceeds from selling an old asset which is being replaced by a new asset.

Answer 39

b) cost of issuing new bonds to finance the new project

Question 40

Atlantic Control Company purchased a machine 2 years ago at a cost of $70,000. The machine is being depreciated using simplified straight-line over its 7-year class life. The machine would have no salvage value at the end of year 7, but could be sold now for $40,000. A new replacement machine can be purchased for $80,000. The new machine would be depreciated over 5 years. Rapidly changing technology has necessitated this project. Delivery and installation charges will amount to $10,000 and net working capital investment of $5,000 will be required at installation. The new machine will not increase sales, but will reduce operating costs by $20,000 per year.
The firm’s tax rate is 21%. What is the initial outlay for the project?

a) ($57,100) d) ($95,000)
b) ($35,000) e) ($52,900)
c) ($55,000)

Answer 40

e) ($52,900)

Question 41

For the previous problem, what is the annual cash flow for years 1 through 5?

a) $17,480 d) $19,650
b) $19,300 e) $16,500
c) $18,600

Answer 41

a) $17,480

Question 42

Your firm is replacing a manually-operated machine with a fully automated machine. The old machine was purchased 5 years ago, had an original depreciable value of $140,000, and is depreciable using simplified straight-line for 10 years. The old machine has maintenance and defects costs totaling $9,000 per year. The current salvage value of the old machine is $12,000. The new machine costs $80,000 with shipping costs of $2,000. The new machine would be depreciated over 5 years using simplified straight line, and would have no salvage value after the fifth year. The new machine would have maintenance and defects costs totaling $4,000 per year.

The tax rate is 21%. What is the annual cash flow for years 1 through 5 (not including the terminal cash flow) if the project is undertaken?

a) $5,000 d) $2,054
b) $2,600 e) $3,950
c) $4,454

Answer 42

c) $4,454